On My Radar: Valuations, Forward Returns and Recession

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“Of the nine market declines associated with recessions that started with valuations above the mean, the average decline was -42.8%. Of the four declines that began with valuations below the mean, the average was -19.9%” – Doug Short

I don’t believe a recession is imminent. The global economy is in trouble but for now the U.S. looks to be in OK shape. Not great, no recession, not yet. This week, let’s take a look at a number of different valuation measures. You’ll see that the conclusion is the market remains richly priced. As Doug Short correctly points out in the quote above, it is during recessions that the biggest equity market declines happen.

One of the tricky things about recessions is that they are only known in hindsight. Defined as a period of temporary economic decline during which trade and industrial activity are reduced, a recession is generally identified by a fall in GDP in two successive quarters. GDP is known only after the end of the quarter that is being calculated and there are often revisions so we only know a number of months after the start. Not too helpful in avoiding that nasty -42.8% average decline.

However, there is something we can do. Historically, the stock market has served as a leading recession indicator and in its behavior we find some helpful information. Below, I share with you my favorite recession watch indicator. I think you’ll find it very interesting.

As I’ve been posting in Trade Signals, I believe we are in a “sell the rallies” environment. The Fed’s September announcement is next week and all eyes are on them. All ‘bout that Fed. My bet is they stand pat. The CME Group posts a FedWatch indicator which is currently predicting a 24% probability of a rate increase. If the Fed raises rates, expect fireworks in the market.

Along those lines, famed hedge fund manager David Tepper was on CNBC this week. I provide a link to several video clips. I liked what he had to say.

Included in this week’s On My Radar:

  • Valuations (High)
  • Probable Forward 10-year Returns (Low)
  • U.S. Recession Watch
  • David Tepper – Good Time To Take Money Off The Table
  • Trade Signals – Extreme Pessimism and No Immediate U.S. Recession Are Two Positives

Valuations (High), Probable Forward 10-year Returns (Low)

Let’s take a look at several different valuation measures:

1. Doug Short looks at four popular valuation measurements and plots them on the next chart. The Red arrow marks where we are as of 8/30/15. In summary, only 1929 and early 2000 were higher than today (with the exception of last month’s reading).

Here is a summary of the four market valuation indicators we update on a monthly basis.

  • The Crestmont Research P/E Ratio (more)
  • The cyclical P/E ratio using the trailing 10-year earnings as the divisor (more)
  • The Q Ratio, which is the total price of the market divided by its replacement cost (more)
  • The relationship of the S&P Composite price to a regression trendline (more)

2. Median P/E (NDR calculation)

This measure looks at actual reported earnings data through August 31, 2015 (not the often unreliable forward earnings estimates Wall Street produces). If we use actual numbers and compare the current number to the actual historical numbers we can get a good sense of levels of over, fair and undervaluation.

Overvaluation, based on median PE, is a reading of 22 or more. The current reading is 20.8 down from 21.8 a month ago. Not as overvalued as some of the measures you’ll see today but at 20.8, median PE remains in the 5th most expensive category since 1924 (sorting PE’s from 1 = cheapest to 5 = most expensive). That can tell us a lot about forward returns as you’ll see a little farther down in this piece (hint: low).

3. Next is a quick look at a number of popular valuation measures. Whether it’s median PE, Shiller PE, Price to Operating earnings, Price to Wall Street’s Forward Earnings, Price to Sales, Price to Book, Cash flow, Dividend Yield, etc., most readings are Moderately or Extremely Overvalued.

Source: data from S&P Capital IQ Compustat, BLS – Burear of Labor Statistics, NDR, Robert Shiller, S&P DJ Indices

4. And this is from AQR – Same conclusion: the market is richly priced.

10-Year Probable Forward Annualized Returns

It is important to note that valuation measures are very poor at signaling market tops as expensive can grow to become even more expensive; however, they are good risk measurement tools and can tell us a great deal about forward expected returns.

Next you’ll see two charts. Both break down median PE into five categories (quintiles) from 1 to 5 with 1 being the lowest 20% of median PE readings and 5 being the highest 20% of median PE readings. It then looked at the median total annualized return of the subsequent 10-years if your starting place was in quintile 1, 2, 3, 4 and 5. Not surprisingly you get a much better return when you buy into the market when valuations are cheap.

With a current Median PE reading of 20.8 (above), that puts the market in Quintile 5 (most expensive). Expect low forward returns. Expect 2% to 4% annualized returns, before inflation, over the next 10-years.

Exhibit 1: 10-year Median Total Return (1926-2014)

Exhibit 2: 10-year Median Total Return (1984-2014)

Source: data from Ned Davis Research

U.S. Recession Watch

Ok, forward returns are not promising at the current high valuations. A better entry lies ahead.

The big risk for us investors (as you’ll see below) happens during a recession. We can recover fairly quickly from the minus ten percent’ers. Minus twenty is a bit more challenging but a minus fifty percent is a killer; needing a subsequent 100% gain and likely years to recoup. So let’s keep a close eye on a recession.

My favorite U.S. Recession Watch Process

Plot the S&P 500 vs. its five-month smoothing. Moves above the smoothing (think moving average) by 4.8% equals expansion. Drops below the smoothing by 3.6% equals contraction.

  • Looking at data from 1948 through August 2014 shows that the above simple process identified a high percentage of expansion and contraction signals with an accuracy rate of approximately 79%.
  • Recently, the S&P 500 dropped below its five-month smoothing but less than 3.6%.
  • Month end data is used for this process. It will be interesting to see what the September month end data will look like.

So far, no recession indication but we seem to be inching in that direction. This process is a monthly process. I’ll post the Recession Watch update again in early October.

Why we must watch out for recessions:

Next paints a good picture as to why we must watch out for recessions, especially when the starting point is an expensively priced market.

Beginning with the market peak before the epic Crash of 1929, there have been fourteen recessions as defined by the National Bureau of Economic Research (NBER). The table above lists the recessions, the recession lengths, the valuation (as documented in the chart illustration above), the peak-to-trough changes in market price and GDP. The market price is based on the S&P Composite, an academic splicing of the S&P 500, which dates from 1957 and the S&P 90 for the earlier years (more on that splice here).

How Long Can Periods of Overvaluations Last?
Equity markets can stay at lofty valuation levels for a very long time. Consider the chart posted above. There are 1369 months in the series with only 58 months of valuations more than two Standard Deviations (STD) above the mean. They are:

  • September 1929 (i.e., only one month above 2 STDs prior to the Crash of 1929)
  • Fifty-one months during the Tech bubble (that’s over FOUR YEARS)
  • Six of the last seven months have been above 2 STDs Source: www.advisorperspectives.com

Standard deviation defined: Standard deviation is a statistical measurement that sheds light on historical volatility. A large dispersion tells us how much the return is deviating from the expected normal returns. Investopedia

Here is a Quick Economic Snapshot – No Global Recession Just Yet, U.S. Best Global Economy

Following are a few bullet points on the economy. In short, the data is mixed. However, I believe it is the equity market that will give us the best indication (as noted in the above section).

  • Reported this morning: The University of Michigan Preliminary Consumer Sentiment for September came in at 85.7, a decrease from the 91.9 Final August reading. Investing.com had forecast 91.2 for the September Preliminary. This 6.2 point decline is the largest since September 2013 and the current preliminary sentiment is at its lowest level since September of 2014.
  • Job openings recently surged. Overall, labor demand continued to strengthen. Job openings jumped 8.1% in August – the most since March 2012. A new record high of 5.753 million
  • Over the twelve months, the job openings rate has increased significantly across most industries, led by professional and business services
  • An interesting statistic is the “quit rate”: it is near the highest level since the spring of 2008. Simply, workers have more confidence to quit their jobs believing they are able to find new ones.
  • With job openings surging to new highs and worker confidence growing this could lead to rising wage pressure – better incomes for workers
  • Mortgage refinancing and new home purchases are growing at double digit rates.
  • Demand for housing is strong and lenders are lending.
  • Credit conditions are favorable
  • Retail sales are ok but not great. The Weekly Retail Chain Store Sales Index showed its best uptick in several months but remains below its 52-week average.
  • Low gasoline prices are a positive for retail sales growth yet overall sales growth is growing at its slowest pace in three years (Redbook sales numbers)
  • There is a pick-up in commercial construction
  • Overall the economy looks to be ok. No signs of U.S. recession

David Tepper – Good Time To Take Money Off The Table

The title of this section pretty much sums it up. David was on CNBC Thursday morning from 8am to 9am. Here is the link to the video clips. Well worth the time.

Trade Signals – Extreme Pessimism and No Immediate U.S. Recession Are Two Positives

I remain in the “sell the rallies” mind set. Most all other indicators are negative on equities. The Zweig Bond Model is once again bullish on bonds. Our HY Managed Bond Program has been in a buy for several weeks.

Included in this week’s Trade Signals:

  • Cyclical Equity Market Trend: Sell Signal

  1. CMG NDR Large Cap Momentum Index: Sell Signal
  2. 13/34-Week EMA on the S&P 500 Index: Sell Signal
  3. NDR Big Mo: Neutral – Nearing a Sell Signal

  • Volume Demand is greater than Volume Supply: Sell Signal for Stocks
  • Weekly Investor Sentiment Indicator:

NDR Crowd Sentiment Poll: Extreme Pessimism (short-term Bullish for stocks)
Daily Trading Sentiment Composite: Extreme Pessimism (short-term Bullish for stocks)

  • Don’t Fight the Tape or the Fed: Indicator Reading = -1 (Negative for Equities)
  • U.S. Recession Watch – My Favorite U.S. Recession Forecasting Chart: Signaling No Recession
  • The Zweig Bond Model: Buy Signal

Concluding thoughts

Valuations are high and forward 10-year annualized returns look to be in the 2% to 4% range (returns annualized before inflation is factored in). The S&P 500 is likely to decline significantly during the next recession. Is it different this time? Not a bet I’m willing to take.

I recommend hedging your equity exposure and increasing your allocation to tactical and other alternative types of strategies that are not solely dependent on an up-trending bull market to make money. I favor a mix of 30% equities (hedged), 30% fixed income (tactically/flexibly managed), 40% alternatives (a mix of a number of liquid non-correlating tactical and alternative strategies).

With kind regards,


Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.

Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman, CEO and CIO. Steve authors a free weekly e-letter titled, On My Radar. The letter is designed to bring clarity on the economy, interest rates, valuations and market trend and what that all means in regards to investment opportunities and portfolio positioning. Click here to receive his free weekly e-letter.


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